Gap Trading: How to Play the Gap

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Gap Trading: How to Play the Gap

Large increases in asset values may benefit traders in unpredictable markets if they can be converted into opportunities. Gaps on a chart are regions when the price of a stock (or another financial instrument) goes quickly up or down with little or no trade in between. As a consequence, the chart of the asset reveals a gap in the typical price pattern. The astute trader can understand and benefit from these gaps. This article will explain how and why gaps develop, as well as how to exploit them to generate winning trades.

Key Takeaways

  • Gaps are areas on a chart that appear when the price of a financial instrument swings dramatically with little or no trade in between.
  • Unexpected gaps develop when the apparent value of an investment varies owing to underlying fundamental or technical variables.
  • Based on when they occur in a price pattern and what they represent, gaps are classed as breakaway, exhaustion, frequent, or continuation.

Gap Basics

Gaps emerge as a result of fundamental or technological issues. For example, if a company’s results are much better than projected, the stock may surge the next day. This signifies that the stock price began higher than it closed the previous day, resulting in a gap. It is not unusual in the forex market for a report to create so much talk that it expands the bid and ask spread to the point where a big gap may be visible. Similarly, a stock that makes a new high in the current session may open higher in the following session, creating a technical gap.

Gaps can be classified into four groups:

  • Breakaway gaps appear at the conclusion of a pricing pattern and indicate the start of a new trend.
  • Exhaustion gaps occur at the conclusion of a price pattern and indicate a last effort to reach new highs or lows.
  • Common gaps cannot be included in a pricing pattern; they simply show a price gap.
  • Continuation gaps, also known as runaway gaps, arise in the midst of a price pattern and suggest a rush of buyers or sellers who have a shared opinion in the future direction of the underlying stock.
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To Fill or Not to Fill

When someone claims a gap has been filled, it signifies the price has returned to its pre-gap level. These fills are fairly prevalent and are caused by the following factors:

  • Irrational exuberance: The original increase may have been too optimistic or gloomy, necessitating a correction.
  • Technical resistance: When a price goes abruptly up or down, it leaves no support or resistance behind.
  • Price Pattern: Price patterns are used to categorize gaps and may predict whether or not a gap will be filled. Exhaustion gaps are the most likely to be filled because they mark the conclusion of a price trend, but continuation and breakaway gaps are far less likely to be filled since they are used to confirm the present trend’s direction.

Fading occurs when gaps are filled on the same trading day on which they arise. For example, suppose a business reports excellent profits per share for the current quarter and then gaps up at the open (meaning it opened significantly higher than its previous close).Let’s imagine that as the day passes, individuals see that the cash flow statement has certain flaws and begin selling. The gap is eventually bridged when the price reaches yesterday’s closing. Many day traders use this method during earnings season or other periods of excessive excitement.

How to Play the Gaps

There are several tactics for exploiting these gaps, with a few being more popular than others. When fundamental or technical reasons support a gap on the following trading day, some traders will purchase. They could, for example, purchase a stock after hours after a favorable earnings report is revealed, looking for a gap up the next trading day. Traders may also enter or exit extremely liquid or illiquid positions at the start of a price movement, hoping for a strong fill and a continuation of the trend. For example, they may purchase a currency when it is rapidly increasing in value due to a lack of liquidity and there is no strong opposition overhead.

  Support and Resistance Basics

Once a high or low point has been found, some traders may fade gaps in the opposite direction (often through other forms of technical analysis).For example, if a stock gaps up on a speculative report, skilled traders may short the stock to close the gap. Finally, traders may purchase when the price level approaches the previous support level after the gap has been closed. This method is shown in the following example.

Here are some crucial points to keep in mind while trading gaps:

Gap Trading Example

To connect these concepts together, consider a simple gap trading method designed for the forex market. This approach predicts retracements to a past price using gaps. Here are the guidelines:

  1. The deal must always be in the price’s general direction (check hourly charts).
  2. On the 30-minute charts, the currency must gap dramatically above or below a critical resistance level.
  3. Price must return to the first resistance level. This indicates that the gap has been closed and the price has returned to the previous resistance turned support.
  4. There must be a candle indicating that the price will continue in the direction of the gap. This will assist to guarantee that the support remains intact.

Because the forex market operates 24 hours a day (from 5:00 p.m. EST on Sunday to 4:00 p.m. EST on Friday), gaps in the market show as huge candles on a chart. These big candles are often caused by the publication of a report, which causes significant price changes with little to no liquidity. The only obvious gaps on a forex chart occur when the market reopens after the weekend.

Let’s look at an example of this system in action:

Image by Julie Bang © Investopedia2020

The huge candlestick shown by the left arrow on this GBP/USD chart is an example of a forex market gap. This does not seem to be a normal spread, but the absence of liquidity between the prices makes it such. Take note of how these levels work as significant degrees of support and opposition.

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Figure 1 shows that the price gapped up over some consolidation resistance, retraced and filled the gap, and then began its journey up before falling again. We can observe that there is minimal support below the gap until the previous support is reached (where we buy).A trader might potentially short the currency on the way down to this point and look for a top.

Gaps are dangerous because of their limited liquidity and high volatility, but if skillfully handled, they may provide rapid rewards.

The Bottom Line

Those who investigate the fundamental causes of a gap and accurately identify its nature may often trade with a high likelihood of success. However, there is always the possibility that the deal may fail. To begin, keep an eye on the real-time electronic communication network (ECN) and volume. This will give you an indication of where various open deals are at. If you find high-volume resistance preventing a gap from being filled, double-check your trade’s premise and consider not trading it if you are not totally sure it is accurate.

Second, ensure that the rally has ended. The market does not always quickly remedy irrational enthusiasm. Stocks may often soar for years at exorbitant valuations and trade high on rumors without a correction. Before entering a position, wait for dropping and negative volume. Finally, while trading, always utilize a stop-loss order. It is preferable to set the stop-loss level below important support levels or at a fixed percentage, such as -8%.

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